Financial Education

Strategic allocation sets the investor’s long-term exposures to systematic risk. Tactical asset allocation (TAA) involves short-term adjustments to asset weights based on short-term predictions of relative performance.

While strategic allocations are revisited only periodically or when there is a change in the investor’s circumstances, TAA is an active, ongoing discipline. In effect, it is active management at the asset class level. It often takes place as an interim step between the strategic asset allocation and the actual asset class management decisions. Alternatively, the asset management can be set and a derivative overlay strategy used to alter the asset class weights tactically.

Tactical asset allocation is based on three principles:

1. Market prices explicitly describe the returns available (either cash yield or a yield + growth formula)
2. Relative expected returns reflect relative perceptions of risk
3. Markets are rational and mean reverting

Tactical asset allocation frequently seeks asset classes where risk premia are well above normal levels in anticipation of mean reversion. This requires judgment, as the mean reversion process can take many years.

Investors wanting exposure to commodity prices in their portfolio can gain exposure either directly or indirectly.

Direct investment in commodities has traditionally taken the form of cash purchase of physical commodities such as metal, oil or agricultural products. The development of derivatives markets has resulted in most of the direct commodity transactions involving futures products. Direct investment obviously provides a direct link to commodity prices, but can require possession, storage, financing, insurance and transaction costs which are either paid directly or through the basis in the futures contract.

Indirect investment in commodities is typically manifest as buying the equities of a commodity producer such as a mining company. It does not provide a direct exposure to the commodity prices, in part because many producers uses hedges to control their own exposure.

Skilled managers are likely to be able to identify stocks that are priced too high as well as those that are underpriced. Theoretically, this skill should be maximized by using a market-neutral (long-short) portfolio in which each long position is matched by a corresponding short sale. However, over the long term stock prices generally rise, and investors may wish to capture this general market exposure (beta).

One way to capture Beta while maximizing manager skill (alpha) is to equitize the market neutral portfolio by holding index futures contracts.

Rather than buying the stocks in an index individually, a fund can gain exposure to all of the stocks at once using either basket (program) trades or stock index futures. A single S&P 500 futures contract provides exposure to 250 times the value of the S&P 500, while the e-mini futures contract provides 50x exposure. These contracts are very liquid, so a fund can gain exposure with minimal transaction costs.

Furthermore, by using an exchange of futures for physicals, the fund can use the futures as a low-cost way to gain access to a fully replicated portfolio. This can be useful because an all-futures portfolio must be rolled over periodically as futures expire in order to maintain appropriate exposure.